What are the essential components of an Investment Policy Statement (IPS)?

The Investment Policy Statement (IPS) is the governing document for a client's investment program. It's arguably the most tested topic on CFA Level III constructed-response questions.

The IPS Framework: Return + Risk + Constraints

Section 1: Return Objective

• State the required return to meet the client's goals
• Distinguish between:
• Required return: Minimum return needed to fund liabilities (e.g., pension obligations, retirement spending)
• Desired return: Client's aspirational target (may exceed what's achievable)
• Express as nominal or real, pre-tax or after-tax

Section 2: Risk Objective

• Define the client's ability and willingness to take risk
• Ability depends on: time horizon, wealth relative to needs, importance of goals, financial flexibility
• Willingness depends on: psychological comfort, past behavior, stated preferences
• When ability and willingness conflict, the more conservative assessment governs

Section 3: Investment Constraints (TTLLU)

Common Exam Mistakes

1. Confusing required and desired return: The IPS should focus on the required return, not the client's aspirational wish
2. Ignoring ability/willingness conflict: If a young, wealthy client says they're very conservative, ability is high but willingness is low — use the lower risk tolerance
3. Forgetting to adjust for taxes and inflation: If the client needs $200K/year in today's dollars, the return objective must account for both taxes and inflation
4. Missing liquidity needs: A client planning a $500K home purchase in 6 months has a near-term liquidity constraint

Example: Rebecca Thornwell, 58, recently retired. Portfolio: $8M. Annual spending: $250K after-tax. Inflation: 2.5%. Tax rate: 25%.

Required pre-tax real return: $250K / (1 - 0.25) = $333K pre-tax → $333K / $8M = 4.17% real pre-tax.

Required nominal pre-tax return: 4.17% + 2.5% ≈ 6.7% (additive approximation) or (1.0417)(1.025) - 1 = 6.77%.

Risk: Ability is above average (large portfolio relative to needs, long horizon to life expectancy ~30 years). Willingness: moderate (recently retired, no future income). Overall: moderate risk tolerance.

For the CFA Level III exam, practice writing complete IPS sections within the time constraint. Our CFA III community has sample constructed responses for peer review.